Credit enhancement

The result is that multiseller securitization conduits typically utilize both liquidity facilities and credit enhancement. Providers of liquidity facilities often insist that conduits obtain credit enhancement as well to emphasize that the liquidity facilities providers are ensuring only timeliness of payment and not guaranteeing against ultimate loss. They also may require credit enhancement if they are uncomfortable with the structure or the level of security of a given transaction. 

Because liquidity facilities and credit enhancement significantly reduce risk on securities issued by a multiseller conduit/ rating agencies base their evaluations of such securities primarily on the liquidity and credit enhancement facilities that the conduit obtains. Obtaining these facilities will, however, add to transaction costs, and their value in reducing interest costs must be adjusted accordingly. "... 

The preceding sections discussed how variations in securitization structures can affect direct transaction costs and flexibility. Each structure is also associated with certain indirect costs and benefits. For example, transaction costs are not limited to direct expenses, such as fees for lawyers, investment bankers, and liquidity or credit enhancement facilities. They also arise from the true sale requirement. ... 

To achieve a true sale, an originator must limit, if not forego, its right to the residual value of the receivables sold to the SPV. This residual value can often be significant since the SPV must obtain a level of receivables well in excess of the amount necessary to pay the securities issued by the SPV. Such "overcollateralization" is needed to assure investors and providers of liquidity and credit enhancement that they will not suffer losses from delayed collection or defaults. Conflict may develop over the amount of overcollateralization necessary for the SPV originators want the level of overcollateralization to be low, while investors and credit enhancers want it to be high. Because the amount of receivables... 

For a discussion of the types of liquidity facilities and credit enhancement available in different settings, see ScHWarcz, supra note 6, at 13-15 Salathe, supra note 13, at 552. 

In the author s experience, the cost of credit enhancement ranges between 0.40% and 0.75% of the amount of credit extended, and the cost of liquidity ranges between 0.15% and 0.35% of the amount of the commitment made available. These amounts fluctuate depending on the particular transaction and the supply of suitable parties willing to provide such enhancement or liquidity. 

The effect of a switch from sequential to pro rata redemption will stop the gradual erosion of excess spread but this will be accompanied by a reduction in the rate of improvement in credit enhancement. 

The credit enhancement for a particular class of notes is the sum of all the credit support provided by the subordinated notes (if any), the reserve fund, and the protection provided by the excess spread. As the collateral is paid down and the notes redeemed, the credit enhancement for all classes of notes will improve. This steady improvement is the main reason behind the ratings upgrades in European RMBS. 

Exhibit 11.11 illustrates how the credit enhancement (excluding excess spread) improves during the life of a pass-through transaction. The exhibit corresponds to the generic paydown profile shown in Exhibit 11.9, and illustrates the reduced rate of improvement in credit enhancement once the notes are paying down on a pro rata basis. 

EXHIBIT11.il Example Credit Enhancement Growth (% of subordination)... 

The credit enhancement in the master trust transaction is the sum of all the credit support provided by the subordinated notes (if any), the... 

The calculation of credit enhancement for notes in a master trust transaction seems more complicated than in a traditional pass-through transaction because subordinated notes from an earlier series are expected to be redeemed before the senior notes of later series. However, if the mortgages were to perform poorly, the trigger events ensure that all outstanding junior notes would only be repaid after all the senior notes. So the credit enhancement can be calculated as the aggregate balance of subordinate notes as a proportion of the total notes outstanding. 

Excess spread is available to build up the reserve fund to its required level and cover any principal deficiencies. For example, in the Holmes Financing transactions there is a mechanism whereby, if the yield on the mortgages falls below a certain specified level, excess spread will be trapped in a second reserve fund to provide additional credit enhancement as compensation for the reduction in excess spread. 

The performance analysis of pass-through transactions will be similar in many respects to that described above. However, as the collateral pays down, the credit enhancement in the transaction will improve and therefore these transactions become more financially robust as they age. 

A typical issue will feature a triple-A rated tranche, a single-A rated tranche, a triple-B rated tranche and a dynamic spread account. The subordination structure for a typical credit card issue is shown in Exhibit 13.8. In this example, the class A noteholders benefit from the subordination of the class B and class C notes, which together provide 12% credit enhancement. The class B noteholders benefit from the subordination of the class C notes, which provide 7% credit enhancement. The class C noteholders benefit from a dynamic spread account. 

The amount of credit enhancement for a transaction is determined by the rating agencies and varies by issuer depending primarily on the performance of the underlying collateral. Exhibit 13.9 shows total enhancement levels for three recent transactions completed by different issuers. 

A typical auto or consumer loan ABS transaction features one to four tranches, generally rated between triple-A and triple-B. Exhibit 14.11 shows the credit enhancement levels for the FIAT 1, the Globaldrive B, and the PPAF 1 transactions. The three transactions are all structured differently and as such, the senior notes in each issue benefit from different levels as well as types of credit enhancement. 

EXHIBIT 14.11 FIAT 1, Globaldrive B and PPAF 1 Credit Enhancement Structures... 

The FIAT 1 issue benefits from a credit enhancement level of 11% from subordination of the unrated class M notes. The Globaldrive B issue benefits from 4% credit enhancement of the class B notes and a reserve fund, which builds up from 1.8% at the closing date to 2.75% of the balance of the initial pool. Fully funded, the Globaldrive B class A notes benefit from a total credit enhancement of 6.75%. The PPAF 1 issue benefits from a credit enhancement level of 33.3% from subordination of the class B and the class C notes (20.5% and 8.5%, respectively) and a cash reserve of 4.3% of the initial notes balance. 

Strictly speaking, the FIAT 1 transaction does not generate excess spread. This explains the high level of credit enhancement from the unrated class M notes (usually, unrated tranches are either privately sold or kept as an equity tranche by the originator). On the closing date, an amount of notes was issued which was equal to the net present value of all future cash payments due from the collateral (as opposed to the principal balance of the collateral). The discount rate used was the fixed rate payable to the swap counterparty (swap rate plus coupon on the class A notes and all fees associated with the transaction). Structured this way, the receivables always yield the discount rate, leaving no excess spread in the transaction. However, losses on the FIAT 1 portfolio can be covered to a certain degree from interest collections because the structure provides for delinquent principal and defaults to be covered before interest is paid on the class M notes. 

Tranched securities are generally rated by a rating agency, with the rating reflecting both the credit quality of the underlying assets as well as any measures put in place to reduce credit risk, known as credit enhancement. 

Common to all the CDO themes are the use of various forms of credit enhancement. In addition to the natural credit enhancement afford through subordination of sequential pay notes, the following methods... 

Defensive asset Class European ABS securities benefit from embedded strnctnral snbordination and credit enhancements, with excellent credit performance and stability in ratings despite a market environment that was volatile at the time of marketing the issue such that a variety of investors sought access to this specialty asset class. 

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